What is a Negative Pledge Clause?

A negative pledge clause is used when a debtor agrees not to grant a security interest in its assets to another party. The terms of this covenant typically state that, if the debtor does grant a security interest in its assets, that the first creditor will be designated as a co-holder of the lien. This approach ensures that the creditor will not be left out of the race to secure the debtor’s assets in the event of the debtor's bankruptcy. If the debtor were to then issue a lien despite the presence of the negative pledge covenant, the unsecured creditor will be entitled to damages for breach of contract, but cannot set aside the lien granted by the debtor.

When to Use a Negative Pledge Clause

A negative pledge clause is useful for creditors when they suspect that the financial condition of a debtor is tenuous. It is also used in bond indentures to give assurance to bondholders regarding the security of their investment in the firm, which may result in a slight decrease in the interest rate that investors are willing to accept from the issuer. The clause may also be inserted into a mortgage agreement.